Download Lecture 4: Supply and Demand

Economics for CED
Noémi Giszpenc
Spring 2004
Lecture 4: Micro: Supply and Demand
March 16, 2004
What’s demand again?
• Back in lecture 2, we learned where effective
demand comes from:
individuals equating the marginal utility of
goods to the market price of goods
• In general, a change in prices affected
quantity demanded, depending on
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Good being normal or inferior
Elasticity
Income
Substitutability of other goods
Durability of good (time factor)
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How does demand add up?
• In a population, if there are many
different people with demand, all of
these individual demands add up to one
Market Demand.
• Additional demand will tend to make
Market Demand more elastic--the
bigger the market, the more elastic.
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A simple demonstration
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Individual
demands…
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to market
demands.
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OK, so what’s supply again?
• Firms’ willingness to sell depends a lot
on the firms’ costs.
• In general, firms will wish to maximize
profit, which they do by producing at the
point where marginal revenue (which for
price-takers works out to be market
price) equals marginal cost.
– (As long as the price is above the average
cost of production.)
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What happens when they meet?
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Equilibrium!
Buyers demand a certain quantity at a certain price
Sellers provide that quantity at that price
Such a price allows supply to match demand
– No one who would like to make a mutually beneficial trade is
left out
– Many who would have paid more or sold for less get a
bargain (this is called consumer and producer surplus)
• When this happens in many markets (for many
goods), it is called general market equilibrium
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Here is what it looks like:
Price
Consumer surplus
Supply
(willingness
to sell)
Peq
Demand
(willingness to buy)
Producer
surplus
Qeq
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Is market equilibrium efficient?
• The satisfaction buyers derive from the last
dollar’s worth of each good equals the last
dollar’s worth bought of every other good
• The goods are sold at marginal cost, meaning
the last dollar spent producing each good
brings the same return as the last dollar spent
producing the other goods.
– Land, labor and capital are put to uses that most
efficiently satisfy customers’ preferences
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Fundamental principle of
microeconomics
• IF all goods, services and resources are
paid for by those who benefit from them
• AND the payment is at P-competitive
equilibrium prices (more on this later)
• THEN output quantities are efficient
– Externalities or lack of competition
undermine these assumptions
– Also, efficiency may not be society’s goal
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“…to the extent that the markets work
efficiently, producers supply the effective
demands that arise from the distribution
of spending power. That use of the
available resources can only be as good,
socially speaking, as you believe the
distribution of spending power to be.”
--Hugh Stretton, Economics: A New Introduction, p. 486
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How do we know it’s equilibrium?
• If the price is below Peq, there is excess
demand.
– Buyers will compete against each other
and bid up the price
• If the price is above Peq, there is excess
supply.
– Sellers will compete to sell by lowering
price
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How does the price move?
• There can be movements along a supply or
demand curve
– A change in quantity leads to a change in price, or
a change in price leads to a change in quantity
• There can be shifts in the supply or demand
curves
– Think of these as movements right or left, not up
or down
– Caused by changes in tastes, technology, costs
(prices of inputs, natural conditions), income,
population, expectations, prices of other goods…
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The carrot example
1. People grow fonder of carrots
•
Demand curve shifts right, causing
movement along supply curve to reach
new equilibrium in short run
2. Genetic super-carrots grow faster
•
Farmers’ costs fall--they increase volume
and drop prices until price=MC:
a shift right in the supply curve
3. People get bored again of carrots
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A graph of the carrot example
S1
price of carrots
S2
E1
E2
E0
E3
D1
D2
bushels of carrots
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What usually happens when
demand increases
1. Producers, wholesalers and retailers meet
the increased demand by running down
inventories, without price changes
2. If new capacity is ready when stores run
out, demand continues to be met; otherwise
prices rise to ration existing product or
attract imports
3. When new capacity ready, if unit costs are
same, prices return to former levels, or fall
further if there are new economies of scale
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Is market equilibrium real?
• Depends on the market.
• Some markets clear very rapidly
– (e.g. international currency exchanges)
• Others have big lags and imbalances
– (e.g. software engineering labor)
• Adjustment time is a huge potential
factor
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“interference” in the market: tax
• What happens to supply and demand
when a tax is imposed?
– Say, a per-quantity (excise) tax
Price that
buyer “sees”
p
p’
Price that
seller “sees”
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tax
S
}
D
D’
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Loss of efficiency / well-being
• In the tax example, assuming all costs
were being accounted for, society lost
something: “dead-weight loss.”
C.S.
p
p’
S
P.S.
government
revenue from tax
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D’
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“interference” in the market:
subsidy
• A subsidy is a payment to the producer
per unit of production--it works exactly
like the excise tax but in reverse
Price that
seller “sees”
p
p’
Price that
buyer “sees”
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subsidy
S
}
S’
D
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What’s wrong with this picture?
• Can you spot the extra cost to society?
Cost to government
of subsidy
S
p
p’
S’
D
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Then why taxes or subsidies?
• Remember that quantities produced are
efficient only if there are no (positive or
negative) externalities.
• Taxes reduce quantities--may be a way to
“internalize” negative externalities
• Subsidies increase quantities--may be a way
to “internalize” positive externalities
• If taxes are for revenue generation, better to
impose them on goods with inelastic demand
– Minimizes the amount that quantities are shifted
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Conditions for perfect competition
• Generally speaking, there are many
alternatives available and known about
• Specifically, the four conditions are
– Many buyers and sellers
– A homogenous (undifferentiated) product (e.g.
wheat, steel)
– Sufficient knowledge (more on this next week!)
– Free entry of new firms
• From legal point of view and
• From cost point of view
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P-competition
• The P stands for perfect or pure, but also for
“price.”
– Remember that to achieve equilibrium, either
excess buyers must bid up price or excess sellers
must cut price
– This competition assumes that all costs are
included in calculation
– Very unusual to have all features exist
• But it is usual for most firms to be “price-takers”
– They cannot affect market price; to them the demand
curves are flat and perfectly elastic
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Conditions of limited competition
• For example,
– Only one seller or buyer
– Sellers or buyers collude not to compete
– Price is fixed by law
– Prices are not a good method of
comparison (information problems)
• buyers or sellers don’t know who else buys or
sells item
• buyers unsure of quality of item offered
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4 types of industries
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Perfect/pure/price-competition
Monopoly (one seller)
Oligopoly (few sellers)
Monopolistic competition (differentiated
products)
– Latter three described in terms of how they
deviate from the first, “ideal” industry
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Features of P-competition
• As mentioned above, firms in a pcompetitive industry face a horizontal
demand curve
• In the short run, it may be possible to
make economic profits, but with free
entry, in the long run, economic profits
always come back down to zero
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Where monopolies come from
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Patents and other intellectual property
Control of an input resource
Created by the government
Decreasing costs with scale (“natural
monopoly”)
• Crime
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What does a monopoly do?
• Maximize profits, of course.
• Since it faces entire market demand, it is not
a price-taker: its output decisions affect the
price. Marginal revenue, in this case, is not
simply the given price.
• Profit = revenue - costs
π = pxQ - C(Q) = demand(Q)xQ - C(Q)
to max. π, choose Q so dπ/dQ = 0
same as saying so marg’l rev. = marg’l cost
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What a monopolist’s decision
looks like
P
(Analysis does not
depend on shape of
MC curve)
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PM
4
3
MC
Peq 2
1
0
0
-1
1
2
3
4
QM
5
6
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8
Qeq
9
Marginal revenue
-2
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Demand
P = 5 - 0.4Q
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Q
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Results of monopoly decisions
Compared to a competitive equilibrium,
• Quantity produced is less
• Price is higher
• There is inefficiency (“deadweight loss”)
Economies of scale and “natural
monopolies” may make p-competition
more difficult, but people have been
creative in creating competition
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What’s an oligopoly?
• From Greek, meaning “a few” sellers
• “A few” means between 1 and many
• The fewer, the more powerful
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Four possible theories about
oligopolist pricing
• Total collusion among few oligopolists
allows them to charge full monopoly
price
• All-out competition and distrust erodes
economic profits down to 0, as in pcompetition
• Somewhere in between
• Indeterminate--cannot be predicted
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So what do oligopolists do?
• Short answer: nobody knows for sure.
• Difficult to predict theoretically, since
behavior is strategic (takes into account
predictions about others’ behavior)
– Can be modeled using game theory
• But are there repeat interactions? Collusion?
How are payoffs structured?
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What is monopolistic
competition?
• Deviates from p-competition only in that
the industry’s products are not
homogenous--they are differentiated.
– the products may be (more or less) good
substitutes, but they are not perfect
substitutes
• Competition occurs on features other
than price--advertising is important
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Industries may combine features
• Oligopolists may engage in monopolistic
competition
– Examples: cars, breakfast cereals
• See next slides for looooong list of
questions to ask about an industry
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The nature of the product
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How durable or perishable is it?
How easy or difficult to store?
How cheap or dear to transport?
What home or foreign trade regulations apply to it?
From first four, is it tradeable or nontradeable?
Is it homogenous or differentiable (e.g. soap)?
Can buyers judge quality before buying, or get help?
What regulation (e.g. quality, safety, labeling) does the
nature of the product attract?
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The method of production
• How long and/or complex is network of producers who
contribute to production of the product?
• What market strength do they have?
• For what purposes do strong ones use strength?
• Are there lead times affecting suppliers’ adjustment to
demand?
• Can producers be informed or communicate at the start
of the lead time to regulate supply?
• Is there fit or misfit between suppliers’ and buyers’ lead
times?
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The method of production (cont.)
• Are there economies or diseconomies of scale?
– Do these tend to produce large/small firms, monopolies,
oligopolies?
• Is there market power through means other than
economies of scale? To what use is it put?
• What regulations (e.g. safety, industrial relations,
environmental care) does the method of production
attract?
• Are suppliers affected by anti-trust or fair-trading
regulations?
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Pricing and marketing
• (repeat): is product homogenous or is there
differentiation?
• How do suppliers price it? Is there monopoly pricing
anywhere in chain?
• Is advertising worthwhile? How much does it add to
price?
• Is marketing affected by public consumer protection
or price control?
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The buyers
• Where in spectrum between necessities and luxuries
is the product? What alternatives are available?
• Are buyers susceptible to advertising?
• Can they judge quality and value of product? Can
they, and do they, get expert help?
• Does buying depend on credit? If so how much is
available to them?
• How much money do they have to spend?
• Whose money do they spend?
• For whose benefit do they spend it?
• Do they have market strength, and do they use it?
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